India States' Deficit Jumps: Central Loans Mask Revenue Strain

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AuthorIshaan Verma|Published at:
India States' Deficit Jumps: Central Loans Mask Revenue Strain
Overview

India's states are facing renewed fiscal pressure as their aggregate fiscal deficit climbed to 3.3% of GSDP in FY25, breaching the 3% mark for the first time in three years. This widening gap is significantly fueled by increased borrowing under the Centre's special assistance program for capital expenditure, masking underlying revenue strains from reduced GST compensation cess and lower central grants. While aggregate debt has moderated from pandemic peaks, it remains substantially above recommended levels, and a rising revenue deficit, coupled with increasing social sector spending, poses long-term fiscal challenges.

### The Widening Deficit & Central Lifeline

India's state governments collectively registered a fiscal deficit of 3.3% of Gross State Domestic Product (GSDP) in FY25 provisional accounts, marking a breach of the 3% threshold after a three-year period of relative containment. This fiscal expansion is significantly influenced by states availing substantial interest-free, 50-year loans from the Centre under the 'Special Assistance to States for Capital Investment' scheme. Between FY24 and FY26, these loans have financed an estimated 0.4–0.5% of GSDP, and are budgeted to fund a substantial portion of capital outlay in FY26. While this influx of funds aims to boost capital expenditure, it adds to state indebtedness and broadens the fiscal deficit, while simultaneously highlighting a growing reliance on central financial support for growth-oriented spending.

### Persistent Debt and Revenue Strain

Despite efforts at debt consolidation, aggregate state debt-to-GSDP moderated to 28.4% in FY25 (revised estimates) from 31% in FY21. However, this remains considerably higher than the 20% recommended by the FRBM Review Committee. Seven major states—Bihar, Andhra Pradesh, Chhattisgarh, Madhya Pradesh, Punjab, Rajasthan, and Kerala—reported deficits exceeding 3.5% of GSDP in FY25. Concurrently, aggregate revenue receipts declined to 12.2% of GSDP in FY25 from 13.7% in FY22. This downturn is primarily attributed to a sharp fall in central grants and a significant reduction in GST compensation cess flows, which have plummeted from ₹1.4 lakh crore in FY21 to ₹0.1 lakh crore in FY25. Consequently, states are intensifying efforts to boost their own revenue sources, increasing their share in total receipts to 58.2% in FY25 from a pre-pandemic average of 55.3%. Despite elevated debt, interest payments as a share of revenue receipts have seen some moderation post-pandemic, partly due to the structure of central loans. However, the revenue deficit is projected to widen to 0.63% of combined GSDP in FY26.

The Bear Case (Forensic Analysis)

Dependence on Central Aid: The projected surge in capital outlay for FY26, estimated at 18% year-on-year to Rs 7.2 lakh crore for top states, is heavily reliant on central government's interest-free loans. While these loans facilitate capital expenditure, they are still liabilities that increase state indebtedness. This growing dependence on central financial lifelines for development expenditure could eventually impinge on states' fiscal autonomy and capacity for independent counter-cyclical fiscal measures.

Revenue Vulnerability: The sharp decline in GST compensation cess, with flows reduced to a trickle, signals a significant loss of revenue support for states. Further, upcoming GST reforms aimed at rate rationalization could lead to revenue shocks for states, with anticipated annual losses ranging from ₹85,000 crore to ₹2 lakh crore according to some estimates. This, combined with a general decline in non-tax revenue and a revenue deficit that is expected to widen, creates considerable revenue vulnerability.

Structural Weaknesses: The aggregate debt-to-GSDP ratio, while down from pandemic highs, remains well above the FRBM Review Committee's recommended 20%. Several states, including Punjab, West Bengal, Bihar, and Rajasthan, carry particularly high debt burdens. Furthermore, increased social sector spending, partly driven by higher cash transfers, is adding pressure to revenue expenditure. The widening fiscal deficit and increased state borrowing are also contributing to upward pressure on bond yields, potentially increasing borrowing costs for both states and the central government.

Future Outlook

The Indian economy is projected to grow at around 7.4% in FY26, providing a backdrop for GSDP expansion. States have budgeted for a substantial rebound in capital spending for FY26, supported by central funding schemes. However, the sustainability of this increased capital outlay, the management of mounting debt, and the ability to bolster own revenues amidst declining central support will be critical determinants of long-term fiscal health for India's states.

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